the Japan carry trade, of all things

The director of the IMF recently gave a clear and concise explanation of the Japan carry trade and how it affects global finance. He did this in a speech at the Harvard Business School alumni dinner which is available on the IMF site. To set the stage, he went over familiar ground: global growth is moderating from recent years but remains high. The decline is welcome since inflation was starting to create dangerous market instability. China and India continue to be the main engines of growth. Risk of a meltdown is slight. (As he put it, the risk of "a disorderly adjustment of global payments imbalances" is low.) However, he added, that the cost of such a meltown would be high.

Continuing to review he said global imbalances continue to be a problem. The sources of imbalance include large deficits the US and large surpluses in Asian export nations and in the oil-rich nations. He warned, as IMF has done for a long time now, that "the imbalances between the United States and the rest of the world are not sustainable over the long term." If they are not reduced gradually, a major upheaval could result. "For example, if investors become suddenly unwilling to hold U.S. financial assets at prevailing exchange rates and interest rates, this could lead to an abrupt change and could cause global financial market disruptions, as well as an economic downturn." He mentioned some small signs of progress in reducing the global imbalances, including a slightly increased exchange rate flexibility in China and slightly increased investing of surplus funds by the oil exporters.

The interesting part of his speech, as I said, concerned the Japan carry trade. Here's what he said:

Another development that gives rise to concern is the growth of the yen carry trade. As you know, this is the practice of borrowing in yen to purchase securities in other countries. The attraction is that Japanese interest rates are low. For example, investors can borrow in Japanese yen, and lend in New Zealand dollars at an interest rate spread of about 700 basis points. The effects of the carry trade can be seen in capital flows into countries like Brazil and Turkey, and in the growth of yen-dominated mortgages in countries ranging from Korea to Latvia. Partly owing to carry trades, and also because of increased international investment by Japanese residents, capital flows out of Japan have risen. As a result, despite a large current account surplus, there has been downward pressure on the yen in the short run. Indeed, in real effective terms, the yen is now at a 20-year now.

The carry trade is not a consequence of global imbalances. Rather, it reflects the globalization of financial markets and the current environment of low volatility and wide interest rate differentials. But it could lead to more entrenched exchange rate misalignments that worsen global imbalances. The depreciating yen led to an increase in the current account surplus of Japan to almost 4 percent of GDP in 2006. Moreover, both financial markets and countries are exposed to risks if there is a sudden reversal of financial flows. For example, a disruptive unwinding of carry trade positions occurred in October 1998, when the U.S. dollar fell by 15 percent against the Japanese yen in four days. Compared to 1998, there are now a greater number of currencies involved in the carry trade and more diversification in the investor base. The latter lessens the risk of an abrupt unwinding of carry trade positions. Nevertheless, I am concerned that investors and the countries into which funds are flowing are not sufficiently attentive to the risks.

There is no simple solution to this problem. The Bank of Japan increased interest rates by a quarter of one percent last week. However, with the economy only just having emerged from years of deflation and inflation still uncomfortably close to zero, it needs to be cautious in increasing rates. Moreover, the decline in home bias and demographic trends in Japan suggests that both institutional and retail flows out of Japan may persist. Therefore, substantial interest rate differentials are likely to remain. Investors will make their own decisions as to what is a safe investment, and at the moment they appear to be relatively complacent about the risks.

Just a few days after de Rato spoke, Japan released stats on its inflation rate showing that its consumer price index had fallen to zero. The account in the Financial Times and other sources point to the dangers. The Bank of Japan will now find it difficult to raise lending rates and that will make it difficult to wind down the carry trade.